Anticipated Regret and the Disposition Effect

Many trading phenomena in financial markets cannot be explained by rational economic models and some even seem contradictory to each other, such as the disposition effect – the tendency of investors to sell winning investments too early and keep losing investments too long in their portfolio – and irrational extrapolation – the tendency of investors to invest too much into recent winners and too little into recent losers. The aim of this project is to understand how investors’ aversion to anticipated regret impacts their trading behavior in financial markets in response to price fluctuations and the conditions under which regret aversion can explain the disposition effect. The answer to this question is highly relevant in the current debate about introducing Personal Retirement Accounts (PRA) to the current Social Security system as empirical evidence suggests that investors with little trading experience exhibit a stronger disposition effect (Dhar and Zhu, 2002).